Upgrading Fixed-Income ETFs To Version 2.0

From the vantage point of logistics, fixed-income ETFs are the greatest thing since sliced bread since they feel, trade, are taxed, and are monitored the same way stocks are. But we’ll have to give up some convenience to in order to avoid getting burned by these products, which seem to have been designed as if rates would fall and bonds would rise forever. Fortunately, two ETF sponsors have already dipped their toes into the waters of what hopefully will become Fixed Income 2.0.

A Bond ETF Is Not A Portfolio Of Bonds

Fixed income ETFs 1.0 is a case in which one plus one equals one half, or something like that. That’s because unlike bonds, fixed-income ETFs don’t mature. As Bond A approaches maturity, the portfolio manager sells it and reinvests the proceeds into another bond.

That may not sound like a bid deal. Managers trade stocks all the time. But bonds are different. They are designed to mature. And this isn’t just a legalistic formality. Bond math, and the arsenal of risk-control tactics available to fixed-income mangers (e.g., managing duration), goes out the window if we cancel the maturities.

A portfolio-average duration can be calculated for any fund at any time based on its current holdings. But the significance of this metric as a risk control device presumes that the holdings will progress one period after another to maturity. That’s why even for professional fund managers, turnover tends to be low. They don’t trade unless they need to. In an ETF, however, the portfolio manager is regularly recalibrating the portfolio to stay in compliance with a targeted duration, so that metric becomes useless as a tool for risk management and is reduced to simply being a marketing bullet point.

It’s fine to eliminate fixed-income risk-control techniques when interest rates are plummeting and bond prices are soaring, as has been the case for most of the time since 1982 and especially in the 2000s, when many of these funds were created. But when rates start rising and bond prices start falling, the absence of risk-control capabilities likens these funds to drag racers driving cars without brakes, as I demonstrated in my last post.

A Potential Solution

If a carmaker builds cars without brakes but learns that customers would like a way to decelerate without crashing into walls, the solution is pretty easy: Start building cars that come with brakes.

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Disclosure: None.

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